Question: Why did the profession of Economic Forecasters "fail" us by not predicting the biggest recession since the 1920's? What improvements need to be made? What can be done. Here, in this page, Im collecting bits and pieces from the conversation around the web. If you would like to add your comments, please feel free to do so. Also, please feel free to link to articles on the subject...
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Table of Contents
"There was a substantial empirical literature from economists like Carmen Reinhart and Graciela Kaminsky (with Ken Rogoff joining in latterly); there was modeling from Guillermo Calvo, Andres Velasco, Nouriel Roubini, Paolo Pesenti, and others, including yours truly (Paul Krugman)" source NYTimes columnist Paul Krugman's blog (response to Economist article below)
In a guest article, Robert Lucas, the John Dewey Distinguished Service Professor of Economics at the University of Chicago, rebuts criticisms that the financial crisis represents a failure of economicsAug 6th 2009
Economists and other readers debate the flaws in economics, and in our articles on its failingsJul 21st 2009 Web only
Although the crisis has exposed bitter divisions among economists, it could still be good for economics. Jul 16th 2009
The past 30 years of macroeconomics training at American and British universities were a “costly waste of time”.
Mr Krugman feared that most macroeconomics of the past 30 years was “spectacularly useless at best, and positively harmful at worst”.
These internal critics argue that economists missed the origins of the crisis; failed to appreciate its worst symptoms; and cannot now agree about the cure. In other words, economists misread the economy on the way up, misread it on the way down and now mistake the right way out.
On the way up, macroeconomists were not wholly complacent. Many of them thought the housing bubble would pop or the dollar would fall. But they did not expect the financial system to break. Even after the seizure in interbank markets in August 2007, macroeconomists misread the danger. Most were quite sanguine about the prospect of Lehman Brothers going bust in September 2008.
For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.
For about a decade before the crisis, macroeconomists once again appeared to know what they were doing. Their thinking was embodied in a new genre of working models of the economy, called “dynamic stochastic general equilibrium” (DSGE) models. These helped guide deliberations at several central banks.
Mr Buiter, who helped set interest rates at the Bank of England from 1997 to 2000... On his blog, Mr Buiter argues that a training in modern macroeconomics was a “severe handicap” at the onset of the financial crisis...
In many macroeconomic models, therefore, insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks. “The model is not, therefore, directly useful for issues where financial intermediation is of first-order importance,” its designers admit. The present crisis is, unfortunately, one of those issues.
models that include such financial-market complications “can be very difficult to handle,” according to Markus Brunnermeier of Princeton, who has handled more of these difficulties than most. Convenience, not conviction, often dictates the choices economists make.
Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter.
The mainstream macroeconomics embodied in DSGE models was a poor guide to the origins of the financial crisis, and left its followers unprepared for the symptoms
He presented the results of simulations from the Fed’s FRB/US model. Even if house prices fell by a fifth in the next two years, the slump would knock only 0.25% off GDP, according to his benchmark model, and add only a tenth of a percentage point to the unemployment rate. The reason was that the Fed would respond “aggressively”, by which he meant a cut in the federal funds rate of just one percentage point. He concluded that the central bank had the tools to contain the damage at a “manageable level”. Since his presentation, the Fed has cut its key rate by five percentage points to a mere 0-0.25%. Its conventional weapons have proved insufficient to the task. This has shaken economists’ faith in monetary policy.
The benchmark macroeconomic model, though not junk, suffers from some obvious flaws, such as the assumption of complete markets or frictionless finance. Indeed, because these flaws are obvious, economists are well aware of them.
a growing number of cutting-edge models incorporate one or two financial frictions. And economists like Mr Brunnermeier are trying to fit their small, “blackboard” models of the crisis into a larger macroeconomic frame.
Unfortunately, it is these primitive models, rather than their sophisticated descendants, that often exert the most influence over the world of policy and practice. This is partly because these first principles endure long enough to find their way from academia into policymaking circles.
Would economists be better off starting from somewhere else? Some think so.
Today’s economists tend to be open-minded about content, but doctrinaire about form. They are more wedded to their techniques than to their theories. They will believe something when they can model it.
Mr Colander, therefore, thinks economics requires a revolution in technique.
Thanks to the seismic events of the past two years, the prestige of macroeconomists is low, but the potential of their subject is much greater. The furious rows that divide them are a blow to their credibility, but may prove to be a spur to creativity.
And how the discipline should change to avoid the mistakes of the pastJul 16th 2009
The Nobel laureate speaks on the crisis in the economy and in economicsJun 11th 2009
Jeffrey Frankel believes that with regards to Why Did Economists Get It So Wrong? Krugman is Right, and adds that while macroeconomists should not be let off the hook for not being more helpful in predicting and handling the crises of the 80’s and 90’s, Frankel believes the field did a better job with the emerging market crisis of 1994-2001.